The effectiveness of fiscal policy: Contributions from institutions and external debts

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JABES
25,1

The effectiveness of fiscal policy:
contributions from institutions
and external debts

50

Nguyen Phuc Canh
University of Economics Ho Chi Minh City, Ho Chi Minh City, Vietnam

Received 2 May 2018
Accepted 2 May 2018

Abstract
Purpose – The effectiveness of fiscal policy is an interesting field in literature of macroeconomics.
The purpose of this paper is to investigate the effects of fiscal policy on economic growth under contributions
from the differences in institutions and external debt levels.
Design/methodology/approach – The authors use panel data from 2002 to 2014 from 20 emerging
markets and use GMM estimators for unbalanced panel data.
Findings – The results show positive growth effects of fiscal policy across emerging markets in the
examined periods. Notably, the improvement in institutions promotes higher crowding-in effects of fiscal
policy. In addition, this paper finds interesting evidences that the external debt has non-linear effects on
economic growth, whereas the heterogeneous effects of fiscal policy on economic growth as positive effects in
low indebted level and negative effect in high indebted level may explain the mechanism of this non-linear
relationship.
Originality/value – This study proposes the non-linear relationship of fiscal growth effects in emerging

economies under the dynamic of debt levels.
Keywords Institutions, Effectiveness, Fiscal policy, External debt
Paper type Research paper

1. Introduction
The field of the effectiveness of fiscal policy has re-highlighted in light of the 2008 global
financial crisis with the new contemporary drivers such as external debt (Ruščáková and
Semančíková, 2016). Due to the complexity of the fiscal process by which it is not fully
captured, different theories provide different answers regarding macroeconomic effects of
fiscal policy and arguments about the suitability and real effects of government
expenditures on economic growth which are still interesting field of study (Bouakez et al.,
2014). Whereas, the main question in the literature of the fiscal policy’s effectiveness is that
whether fiscal policy presents crowding-out and/or crowding-in effects in a country and
what its drivers. In fact, many researchers try to find evidences with the parallel existence of
both and mixed conclusions (see Ahmed and Miller, 2000; Heutel, 2014; Şen and Kaya, 2014).
The effects of fiscal policy on economic growth are driven by many factors such as the
employment in the economy, the transparency of government, the composition of
government expenditures, or even the government size (see Kasselaki and Tagkalakis, 2016;
Hemming et al., 2002). In empirical literature about the determinants of fiscal policy’s
effectiveness, there are, in fact, some studies that consider the role of institutional
framework such as corruption situation, economic freedom, democracy (see Baldacci et al.,
2004; Martinez-Vazquez et al., 2007). Meanwhile, the burdens of external debt on the

Journal of Asian Business and
Economic Studies
Vol. 25 No. 1, 2018
pp. 50-66
Emerald Publishing Limited
2515-964X
DOI 10.1108/JABES-05-2018-0009

© Nguyen Phuc Canh. Published in the Journal of Asian Business and Economic Studies. Published by
Emerald Publishing Limited. This article is published under the Creative Commons Attribution
(CC BY 4.0) licence. Anyone may reproduce, distribute, translate and create derivative works of this
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This paper is funded by the University of Economics Ho Chi Minh City.


sustainability of fiscal policy are also concerned. For instance, Amato and Tronzano (2000)
find the evidence that the debt maturity and the share of foreign-denominated debt are
crucial determinants of exchange rate stability in Italia. Bal and Rath (2014) find that Indian
economic growth is impacted by central government debt, total factor productivity growth,
and debt-services in the short-run. Recent study, Doğan and Bilgili (2014) find that external
borrowing has negative impact on growth both in regime at zero and regime at one, but the
public debt has higher negative effects on economic growth and development, thus they
conclude a non-linear relationship between economic development and borrowing variables.
However, the literature of fiscal policy is lacking of the studies about the effectiveness of
fiscal policy under the contributions from the institutions and external debts in a
comprehensive work. Therefore, this study is conducted under the motivations from the
study of Doğan and Bilgili (2014) by investigating the effectiveness of fiscal policy on
economic growth under the relationships with the changes in the institutions and the
burdens of external debt in the context of 20 emerging markets including Argentina,
Bangladesh, Brazil, Bulgaria, China, Colombia, Egypt, India, Indonesia, Malaysia, Mexico,
Pakistan, Peru, Philippines, Romania, Russia, South Africa, Thailand, Turkey, and Vietnam.
In this paper, we achieve our objectives by implementing following strategy. We first
examine the impacts of fiscal policy on economic growth through the modified model of
endogenous growth theory by incorporating government expenditure and controlling other
common drivers of economic growth including capital, labor, financial development,
technology, economic openness (trade and capital flows). Then, the institutional factors

including government effectiveness, regulatory quality, and control of corruption are
incorporated, respectively, to test the impacts of institutions on economic growth. Next, we use
the interaction terms between government expenditure and institutions to examine the
effectiveness of fiscal policy under the associations of institutional framework. We then
estimate the growth model with the explanatory variables including both external debt level to
GNI and its square to examine the non-linear relationship between external debt and economic
growth. After that, we divide our data into two sub-samples (the low indebted countries and
high indebted countries) to investigate the effectiveness of fiscal policy under two regimes.
By doing this strategy, we believe that this study has significant contributions to both
theory and practice. First, this study has contribution to the literature of fiscal policy
effectiveness and fiscal indebtedness by adding the effects of government expenditures under
the external debt level and the associations with institutional quality. The results find
significant evidences that the institutions enhance the effectiveness of fiscal policy.
Notable, the external debt level presents the non-linear relationship with economic growth
through the mechanism that the fiscal policy has the heterogeneous effects on economic
growth: the crowding-in effect in low indebted level and crowding-out effects in high
indebted one. Second, this study has significant implications for the authorizers in
implementing the long-term sustainable fiscal policy in line with borrowing policy and the
solutions for the high indebted countries that face to the dilemma of ineffective fiscal policy.
This paper is structured as following. Section 1 states our motivations of this study.
Section 2 briefly presents literature reviews and then our arguments on the effectiveness of
fiscal policy under the contributions from institutions and external debt. Methodology and
data are provided in Section 3. Section 4 presents the results and our discussions.
The concluding remarks are discussed in Section 5.
2. Literature reviews
The fiscal policy is considered with a wide range of literature, while the effectiveness of
fiscal policy is seen under its’ impacts on the economic growth and the long-term sustainable
development. In the literature of fiscal policy effectiveness, it is natural place to start with
the Keynesian theory. In Keynesian model, the sticky price and excess capacity are assumed

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that contraries to the classical economics, so that aggregate demand determines output and
government expenditures have a multiplier effect on aggregate demand and output
(Coddington, 1976). This view is also called as the crowding-in effects of fiscal policy, where
the government should undertake the expenditure in the recession time to cover the lack of
private consumption and investment ( Jahan et al., 2014). However, some of extensions in the
line of Keynesian model allow for crowding-out effects of fiscal policy, which means the
expansion of government expenditure crowds out the private demand and then influences
negatively on output, through the changes in interest rates and exchange rate in the case of
open economy. With the assumption that the private investment is negative impacted by the
increase in interest rate, the expansionary fiscal policy that backed by borrowing leads to
the lower private investment due to higher interest rates (see Mundell, 1963; Fleming, 1962).
The neo-classical views focus on the determination of goods, outputs, and income
distributions in markets through both supply and demand sides by adding the assumption
of utility maximization of income-constrained individuals and firms under the boundary of
factors in production and available information (see Davis, 2006). In which, the neo-classical
economics raise the rational expectations in comparing to the adaptive expectations in
Keynesian economics. This brings forward adjustments in economic factors that occur more
progressively so that fiscal policy matters in not only long-term but also short-term period.

And the permanent fiscal changes can lead to the crowding-out effects since private sectors
expect the persistent changes in interest rates and exchange rates in this case (see Buiter,
1977; Arestis, 1979; Mundell, 1963; Fleming, 1962).
In addition to neo-classical economics, the Ricardian view that is based on Ricardian
equivalence theorem assumes that the individuals are forward-looking in the current
activities, which is also in contrasting with the Keynesian economics view as individuals
rely on current income (see Barro, 1989; McCallum, 1984). In Ricardian view, individuals
anticipate a present tax cut as higher government borrowing that turns into the higher
taxes in the future so that there is no change in permanent income. This condition in along
with the assumptions of no liquidity constraints and perfect financial markets lead to no
change in private consumption in general (Barro, 1974). Thus, Ricardian view suggests
neither crowding-in nor crowding-out effects of fiscal policy (Arestis, 2011; Şen and Kaya,
2014). However, if governments change lump-sum taxes for the fiscal policy, the features of
progressive taxes will have impacts on permanent income and then the aggregate demand
and output. As a result, the effectiveness of fiscal policy most likely depends on how it is
paid in the future and the productivity of government expenditures (Hemming et al., 2002).
All above economic views require assumptions to be presence such as no liquidity
constraints, perfect financial markets in Ricardian equivalence. However, these assumptions
are usually un-existed thus the significance of theories is questioned in both theory and
practice (Haque and Montiel, 1989). Furthermore, there are some cases that the effectiveness
of fiscal policy is explained by all of these views. For instance, if government is restricted by
the fiscal rules to balance the fiscal budget in the long run, thus individuals may partial
adjust their behaviors if they have short-term horizon which presents the presence of both
Ricardian and neo-classical views. In the same idea, if the current path of government debt is
not sustainable and future tax increases will be required to lower the debt, the Ricardian
view may be presence in expansionary fiscal policy seemingly with the Keynesian view
which depends on the level of public debt (Sutherland, 1997). Or, if the government
expenditure is in line of an upward-trending stochastic process that individuals believe a
sharply fall when it approaches a specific “target point,” there will be a non-linear
relationship between private consumption and government expenditure (Bertola and

Drazen, 1993). Therefore, the argument of a non-linear relationship between fiscal policy and
economic growth makes sense in literature. However, the literature needs the explanations
for the mechanism and empirical evidences.


Many previous studies have investigated the effects of fiscal policy in many countries,
especially in advanced countries such as USA, Japan, European area[1]. Recently, Afonso
and Strauch (2007) find that the European fiscal policy makes market swap spreads
response in mostly around five basis points or less in 2002. Similarly, the study of Kameda
(2014a) finds that an increasing of 26-34 basis points in real ten-year interest rates in
responding to a percentage point increase in both the projected/current deficit-to-GDP ratio
and projected/current primary-deficit-to-GDP ratios in Japan. Kameda (2014b) documents
that the diffusion index of the attitudes of financial institutions have a definite impact on
fiscal expansion effects. In particular, the government expenditure has non-Keynesian
effects under the demand-enhancing effects if the existence of liquidity-constrained
households when banks’ attitude toward lending is tight and the fiscal condition is bad.
Bhattarai and Trzeciakiewicz (2017) use a DSGE analysis to examine the fiscal policy in UK.
They note the highest GDP multipliers for government consumption and investment in the
short-run, whereas capital income tax and public investment have long-run crowding-out
effect on GDP. Moreover, they emphasize that the fiscal policy presents decreasing effects in
a small open-economy scenario.
Besides the presence of plentiful empirical literature in the effectiveness of fiscal policy,
this field of study got much less evidence on the short-term effects in developing countries
due to data deficiencies, the structural/institutional factors in the last century (see Hemming
et al., 2002). For instance, Haque and Montiel (1989) find that the Ricardian equivalence is
not supported in the developing countries due to liquidity constraints. Montiel and Haque
(1991) go further by using the Mundell-Fleming model with rational expectations and full
employment for 31 developing countries and conclude that the increasing of government
expenditures have contractionary short-term and medium-term effects. Previous, Khan and
Knight (1981) find positive nominal income elasticities of government expenditures and

taxes and they are close to unity in 29 developing countries. Then, other empirical studies
such as Easterly et al. (1994) document evidences that fiscal policy has crowding-out effects
on private investment through the impacts on interest rates in developing countries.
Meanwhile, empirical studies also provide evidences supporting for partial or/and fully
existences of the Ricardian equivalence in developing countries such as Masson et al. (1995),
Giavazzi et al. (2000).
However, the economic development in emerging market economies, which is a new
definition of the development level of economies and nearly relating to the developing
countries definition, boosts their roles in the world economy. In addition, the better fulfill of
data have re-highlighted the interesting in investigating the effectiveness of fiscal policy by
adding more methods and conditions into model for this group. For example, Cuadra et al.
(2010) note that emerging market economies typically exhibit a pro-cyclical fiscal policy,
where governments increase (decrease) expenditures in economic expansions (recessions)
and rise (reduce) tax rates in bad (good) times. This situation is in line with the characteristic
of counter-cyclical default risk in their business cycle. They also note that the incomplete
markets and sovereign default risk premium have important roles in explaining
the pro-cyclicality of public expenditures and tax rates in these economies. Therefore, the
assumptions of Ricardian view are not existed that propose for the Keynesian or
neo-classical views of fiscal policy.
No surprising that the debate on the role and the effectiveness of fiscal policy are
continuous argued broadly in both literature and practice. Recently, Arestis (2011) notices
that the “New Consensus in Macroeconomics,” recent developments in macroeconomics
and macroeconomic policy, downgrades fiscal policy’s roles in contrasting with monetary
policy due to its ineffective. Through a careful literature review and discussion at recent
developments on the fiscal policy literature, he then concludes that fiscal policy does still
have significant roles in economic policy through its impact on allocation, distribution

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and stabilization. However, researchers and authorizers have to careful consider the
assumptions in economic theories of fiscal policy’s effectiveness as Ricardian and
non-Ricardian economic existences, liquidity-constraints, and the endogenization of labor
supply and capital accumulation. Meanwhile, other features of the economy should be
considered in study the effectiveness of fiscal policy such as the institutional framework
and the debt burden.
The dependence of fiscal policy’s effectiveness on institutional aspects is discussed
under the literature with two main strands including the inside and outside lags of effects
and the political economy considerations (Hemming et al., 2002). First, the fiscal policy has
inside and outside lags, where the inside lags present the needed time to see that fiscal policy
should changes, the outside lags are the function of the political process and the fiscal
management that is the time for fiscal measures take effects on aggregate demand (Blinder
and Solow, 1974). Due to the long time to design, approval, and implementation, the inside
lag may be longer, while the outside lag is more variable depending on the institutional
environment. Second, the fiscal policy is impacted by the political considerations such as the
fiscal illusion of public and policy-makers, the favor of transferring current fiscal burden to
future generations, the limitation of government due to the debt accumulation, the delay of
fiscal consolidations due to the political conflicts, and the function of current budget
institutions that leads to high spending.
The institution is defined as the social rules of the game (North, 1990), which includes
“humanly devised,” “the rules of the game” to set “constraints” on human behavior, and the

economic incentives (see North, 1981; Acemoglu and Robinson, 2008). The better institutions
reduce asymmetric information problem, transaction cost, and risk, while they improve the
market efficiency, especially efficiency of asset allocation (Cohen et al., 1983; Ho and
Michaely, 1988; Williamson, 1981). Therefore, the better institutions should have positive
associations with the effectiveness of fiscal policy since the lower asymmetric information
problem, transaction cost, and higher market efficiency reduce both the inside and outside
lags that then increase the efficiency of fiscal policy, especially the short-term effects.
The empirical literature in the field of fiscal policy had considered the role of institutional
framework in some manners such as politics, democracy, economic freedom, and corruption
in recent decades. Nelson and Singh (1998), for instance, argue that a democratic political
system permits active in a voluntary way, at the same time it creates competitive market
forces conditions for economic growth. They also emphasize that the ineffective democracy
regimes in developing countries detriments the growth. Lockwood et al. (2001) add that the
political pressures determine the path of government spending, taxations and borrowing in
Greece in the period 1960-1972, which means the fiscal policy may not follow a long-term
efficiency for the country. Martinez-Vazquez et al. (2007) notice that the elimination of
corruption is not usually an economic objective for the development, but the frustration with
the lack of effectiveness of traditional economic theories and the recognition of the
important roles of institutions and good governance practices have led the more attention to
the corruption. Precisely, Dimakou (2015) finds that corruption constrains the fiscal capacity
in taxations and increases the inflationary reliance.
However, no comprehensive study has considered the fiscal policy’s effectiveness under
the institutional framework. More interesting, it lacks of empirical study in emerging market
economies, which have more space in improving institutional quality and the economic
growth. For example, the study of Aidt et al. (2008) document that corruption has a
substantial negative impact on economic growth in high institutional quality economies,
otherwise it has no impact on economic growth in low quality one. Ho et al. (2016) find that
the improvement in country governance just enhances the effectiveness of banks and then
promote the economic growth in developing countries, while it reduces these effects in
developed countries due to smaller spaces for improvement. In addition, Wang et al. (2014)

argue that the improvements in institutional quality just have strong effects on promoting
economic development only when institutional quality is within a certain range. Therefore,
we can argued that the improvement in institutions has strong impacts on the effectiveness
of fiscal policy in emerging market economies.
The debt burdens, on the other hand, are also concerned in the literature of fiscal policy
effectiveness. According to the review of Hemming et al. (2002), the debt accumulation may
be used as a strategic instrument to limit the fiscal capacity for future government, while the
availability and cost of domestic and external borrowings are often major tackles on fiscal
policy in developing countries. Thus, an emerging market economy with highly level of
debts will determine the size of fiscal deficit in facing with more difficulties in assessing to
international capital market (inaccessible or accessible with unfavorable terms), which then
leads to the stronger crowding-out effects. Meanwhile, the low indebted countries have
higher fiscal room for future government in implementing fiscal policy, which may
undertake with the favorable terms of debt-financing, and that in turn promotes the
crowding-in effects. Moreover, the individuals in high indebted countries are more sensitive
to the government expenditures in following the framework of neo-classical views.
The public may expect that the increasing of government expenditures in this case be in
along with the less favorable terms of government’s borrowings and less efficiency of
spending, which then stimulate individuals to cut back their current consumption more and
more. As a result, this proposes higher crowding-out effects of fiscal policy. In contrast, the
individuals in low indebted countries may less sensitive to the government expenditures,
especially through the debt-financing spending, since the interest rates are less responsive
and they are easier to access the financial markets, thus the fiscal policy is argued with the
existence of crowding-in effects.
According to Kirchner and Wijnbergen (2016), if banks hold substantially sovereign debt
the effectiveness of expansionary fiscal is impaired since deficit-financed fiscal expansions
reduce private access to credit in this case. Therefore, we use the total external debt, which
includes public debt and private debt in this study to examine the impacts of debt on

effectiveness of fiscal policy. This helps us consider the constraints of external debt of
ability of private sector in accessing international financial markets. We argue that the
expansionary fiscal policy in the highly indebted countries not only creates the
crowding-out effects for the private sectors through the impacts on interest rates and
exchange rates, but also crowds out the availability of private sectors in accessing into the
international financial markets that creates more constraints for private sectors to
implement economic activities. In contrast, these effects may not exist or less significance in
the case of low indebted countries. As a summary, our hypothesis is argued that the
relationship between fiscal policy with the economic growth is non-linear one as the positive
effect in the low indebted level and the negative effect in the high indebted level.
In fact, the non-linear relationships between fiscal policy and economic factors are
examined under some manners. Adam and Bevan (2005) investigate the relationship
between fiscal deficits and economic growth for a panel of 45 developing countries and find
evidence of a 1.5 percent GDP threshold deficit effect. They also find evidence that the
deficits in line with high debt stocks exacerbates the adverse consequences of high deficits.
While, Catão and Terrones (2005) examine inflation as non-linearly related to fiscal deficits
through the sample of 107 countries over 1960-2001 period. They find a strong positive
relationship between deficits and inflation among high-inflation and developing country
groups, but it is not true among low-inflation advanced economies.
This fact suggests that we should consider the non-linear relationship between fiscal
policy and economic growth in the emerging market economies. Emerging market
economies are an emerging group of countries with interesting economic features in
developing countries. While, the expected future revenue plays an important role in

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explaining the low fiscal limits of developing countries relating to developed countries
(Bi et al., 2016). Therefore, the study of the relationships between institutions, external debts
and the effectiveness of fiscal policy is more significant for both literature and practice.
Next section presents the methodology and data.
3. Methodology and data
3.1 Methodology
In this paper, we recruit the common determinants of economic growth including capital,
technology, labor, technology, capital flows, trade openness, and add the credit element for
the basic model of economic growth from a vast of literature. With this beginning of basic
model, we incorporate government expenditure to examine the impacts of fiscal policy on
economic growth for 20 emerging market economies in the period 2002-2014, and follows the
empirical model in Miller and Russek (1997):


g i;t ¼ @1 g i;tÀ1 þ@2 gdppci;tÀ1 þaX t þb1 Govexg i;t þet;s with es $ i:i:d:N 0; d2s;t

(1)

where i and t is country i at time t. g is GDP growth rate (gdpg) that proxies for the economic
growth. The lag of g is put into the model to control for the dynamic of economic growth
model, while the gdppc is logarithm of GDP per capita that presents for the starting
economic development level. X is vector of control variables including: the capital
investment factor that presented by the gross capital formation growth rate (capg); the labor
factor that presented by the population growth rate (popg); the credit factor that presented

by the logarithm of domestic credit to private sector by banks (credit); the technology factor
that presented by the logarithm of total patent applications by both residents and
non-residents (patent); the trade openness that presented by the logarithm of total trade to
GDP (trade); and the capital flow that presented by the net inflows of foreign direct
investment to GDP ( fdi). govexg is the proxy for fiscal policy that presented by the general
government final consumption expenditure growth rate. In this study, we use the
government expenditure growth to proxy for the fiscal policy since it presents the changes
in the fiscal policy, while the government revenue and tax have strong correlations with the
government expenditure, thus in order to examine the fiscal policy effectiveness we only use
the government expenditure. Even though the government expenditure can be best proxy
for the fiscal policy.
All the definitions and sources of variables are presented in detail in Table I.
In next step, we also incorporate institutional factors into the model to investigate the
effects of institutional quality on economic growth following the empirical model suggesting
in Lee and Hong (2012). In this step, we collect three dimensions of institutions from World
Governance Indicators (Worldbank) including the government effectiveness (Goveff ),
regulatory quality (Regu), and control of corruption (Concor) to proxy for the institutional
framework, respectively. Despite of critics about bias or lack of comparability and the utility
of institutional quality in World Governance Indicators (Thomas, 2010), there are many
previous studies that use these indicators as the best proxies for institutional quality (see
Zhang, 2016).
Next, we estimate the growth model with the explanatory variables including both
external debt to GNI and its square to examine the non-linear relationship between external
debt and economic growth. Basing on the results of these estimations, we then divide
sample into two sub-samples basing on the level of external debt to GNI (see Table II). Then,
we apply the previous procedures to two sub-samples separately to investigate the
effectiveness of fiscal policy under two debt regimes.


Variables

Definitions

Dependent variables
Gdpg
Real GDP growth rate (% annual)
Independent variables
Control variables
Gdppc
Logarithm of real GDP per capita
Capg
Gross capital formation growth rate (% annual)
Popg
Population growth rate (% annual)
Credit
Logarithm of domestic credit to private sector by banks
Patent
Logarithm of total patent applications by both residents and
non-residents
Trade
Logarithm of trade ratio to GDP (%)
Fdi
Net inflows of foreign direct investment to GDP (%)
Debt
Ratio of External debt stock to GNI (%)
Explanatory
variables
Govexg
General government final consumption expenditure growth rate
(% annual)

Goveff
Government effectiveness indicator
Regu
Regulatory quality indicator
Concor
Control of corruption indicator

Sources
WDI

Calculation from WDI
WDI
WDI
Calculation from WDI
Calculation from WDI

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Calculation from WDI
WDI
WDI
WDI
WGI
WGI
WGI

3.2 Data
Our data are collected yearly from the period of 2002-2014 for 20 emerging countries[2]
due to the time limitation in World governance indicators that have continuous data from
2002 to 2014. The government effectiveness, regulatory quality, and control of corruption
are collected from World Governance Indicators, meanwhile all remained variables are
collected from World Development Index (Worldbank). The data description is presented
in Table II.
The data description shows that emerging market economies have high economic
growth presenting by both average growth rates of GDP and GDP per capita. It is also
noticed that they have high growth rate of investment in line with the target of FDI flows.
Meanwhile, the institutional framework has wide space for improvement since their average
levels are around the zero level (in the range from −2.5 to +2.5 in World governance
indicators report). In addition, the governments in emerging market economies are almost
under the expansionary phrases since their general government consumption growth rates
are positive, but it may diversify among countries due to the high standard deviation.
4. Results and discussions
All our results are presented in the tables from Tables IV-VIII. In which, the estimators are
presented with AR(2) test and Hansen/Sargan test depending on the first difference or system
GMM methods. All the p-value of AR(2) test and Hansen/Sargan test are over 10 percent,
which define the significance of GMM estimators as suggesting in Roodman (2009).
Model (1) in Table III shows the results for basic model of economic growth.
The significant positive impact of lag economic growth to itself shows that the higher
economic growth in current year creates better conditions for growth in next year. This is
easy to understand that the higher economic growth rate provides more sources such as
capital and incentives for economic activities. While, the significant negative effect of log of
GDP per capita with lag on economic growth suggesting the convergence trend in economy
among emerging market group. Other control variables including capital formation,

Table I.
Variables, definitions

and sources


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Variables

Obs.

Full sample (20 emerging markets)
Gdpg
260
Gdppc
260
Capg
260
Popg
259
Credit
260
Patent
257
Trade
260
Fdi
260
Debt

260
Govexg
260
Goveff
260
Regu
260
Concor
260

Mean

SD

Min.

Max.

4.898
8.316
7.078
1.055
3.661
8.363
4.070
3.112
36.591
4.818
−0.063
−0.062

−0.414

3.177
0.865
11.856
0.797
0.657
1.664
0.521
3.114
21.776
4.794
0.424
0.488
0.380

−10.894
6.285
−41.000
−1.911
2.152
5.455
3.096
−0.254
8.251
−9.453
−0.870
−1.100
−1.490

14.195
9.409
48.406
2.254
4.955
13.741
5.349
30.995
163.582
48.324
1.250
0.840
0.580

8 emerging markets with the average external debt level under the 40% GNI including: Bangladesh, Brazil,
China, Colombia, Egypt, India, Mexico, and South Africa
Gdpg
104
5.090
3.033
−4.700
14.195
Gdppc
104
8.191
0.936
6.285
9.376
Capg
104

7.520
7.101
−13.330
31.741
Popg
104
1.301
0.405
0.479
2.254
Credit
104
3.750
0.581
2.564
4.955
Patent
103
9.015
2.016
5.666
13.741
Trade
104
3.787
0.304
3.096
4.289
Fdi
104

2.547
1.671
−0.205
9.344
Debt
104
22.466
8.172
8.251
47.676
Govexg
104
4.760
3.135
−1.190
13.880
Goveff
104
−0.090
0.385
−0.870
0.680
Regu
104
−0.097
0.469
−1.100
0.780
Concor
104

−0.393
0.395
−1.490
0.580

Table II.
Data description

12 emerging markets with the average external debt level above the 40% GNI including: Argentina, Bulgaria,
Indonesia, Malaysia, Pakistan, Peru, Philippines, Romania, Russia, Thailand, Turkey, and Vietnam
Gdpg
156
4.770
3.272
−10.894
9.452
Gdppc
156
8.399
0.806
6.754
9.409
Capg
156
6.783
14.183
−41.000
48.406
Popg
155

0.889
0.941
−1.911
2.121
Credit
156
3.602
0.700
2.152
4.799
Patent
154
7.927
1.202
5.455
10.713
Trade
156
4.259
0.549
3.358
5.349
Fdi
156
3.489
3.741
−0.254
30.995
Debt
156

46.007
22.911
20.493
163.582
Govexg
156
4.858
5.645
−9.453
48.324
Goveff
156
−0.044
0.449
−0.810
1.250
Regu
156
−0.038
0.500
−1.080
0.840
Concor
156
−0.428
0.370
−1.130
0.480

population growth, technology, foreign direct investment inflows, and trade openness have

signs as expected by theories. It is easy to understand that the increasing of capital, labor,
credit, inflow capital, trade openness, and innovations in technology have positive impacts
on economic growth, especially in the case of emerging market economies that have space
for all of these above drivers to contribute on growth. The results are consistent with
literature and many previous empirical results. However, the insignificant positive effect of
domestic credit on economic growth points out the argument that the financial markets in
emerging market economies do not contribute enough to the growth.


Model
Dep. var: GDP growth

(1)
Coef.

(2)
p-value

Gdpg(−1)
0.204***
0.002
Gdppc(−1)
−0.661***
0.000
Capg
0.249***
0.000
Popg
0.614***
0.000

Credit
0.197
0.595
Patent
0.401***
0.008
Fdi
0.321***
0.000
Trade
0.485*
0.091
Govexg
N
212
No. of group
20
AR(−2) test
−0.99
0.324
Sargan/Hansen test
17.45
0.180
Note: *,**,***Significant 10, 5 and 1 percent levels, respectively

Coef.

p-value

0.135***

−0.674***
0.243***
0.315***
0.171
0.421***
0.366***
0.460
0.116*
172
20
0.36
16.74

0.021
0.000
0.000
0.004
0.627
0.002
0.000
0.121
0.055
0.721
0.211

The
effectiveness of
fiscal policy

59

Table III.
Government
expenditure and
economic growth

With main explanatory variable, the growth rate of general government expenditure has
significant positive effect on economic growth. This result suggests the existence of crowdingin effects of fiscal policy in the context of emerging market economies. Thus, our result
supports for the Keynesian views of fiscal policy that the fiscal policy is needed to promote the
economic growth in the emerging market economies since the sources for the growth from the
private sectors are still limited at there and the roles of governments in creating the basic start
for the development of other sectors. In addition, the public sectors still strongly present in
emerging market economies through the state-owned enterprises so that the fiscal policy has
significant impacts on the whole economy through its effects on public sectors.
The most important of our study, the impacts of institutions on the effectiveness of fiscal
policy are examined and presented in Tables IV and V. The estimators prove that the
improvement in institutions including aspects of government effectiveness, regulatory
quality, and control of corruption enhances the effectiveness of fiscal policy in emerging
market economies. In fact, all the interaction terms between government expenditure
Model
Dep. var: GDP growth

(3)
Coef.

(4)
p-value

Coef.

Gdpg(−1)
0.094**
0.034
0.097**
Gdppc(−1)
−0.742***
0.000
−0.590***
Capg
0.235***
0.000
0.238***
Popg
0.347**
0.028
0.299*
Credit
0.019
0.957
0.096
Patent
0.455***
0.000
0.373***
Fdi
0.438***
0.000
0.464***
Trade
0.623*

0.089
0.424
Govexg
0.128**
0.017
0.099*
Goveff
−0.915**
0.035
Regu
−0.918**
Concor
N
172
172
No. of group
20
20
AR(−2) test
0.38
0.707
0.56
Sargan/Hansen test
17.90
0.161
18.24
Note: *,**,***Significant 10, 5 and 1 percent levels, respectively

(5)
p-value

Coef.

p-value

0.032
0.000
0.000
0.064
0.802
0.006
0.000
0.238
0.063

0.079
−0.681***
0.235***
0.391**
0.134
0.399***
0.483***
0.407
0.118**

0.122
0.000
0.000
0.017
0.759

0.009
0.000
0.417
0.017

−0.969*
172
20
0.45
17.23

0.088

0.040

0.574
0.149

0.654
0.189

Table IV.
Institutions and
economic growth


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60

Table V.
Institutions,
government
expenditure and
economic growth

Model
Dep. var: GDP growth

(6)
Coef.

(7)
p-value

Coef.

Gdpg(−1)
0.051
0.534
0.050
Gdppc(−1)
−0.715***
0.000
−0.662***
Capg
0.225***
0.000
0.230***

Popg
0.675***
0.000
0.391**
Credit
−0.312
0.340
0.032
Patent
0.510***
0.002
0.380**
Fdi
0.526***
0.000
0.569***
Trade
0.673**
0.049
0.593*
Govexg
0.142**
0.041
0.099*
Goveff
−2.277**
0.024
Govexg × Goveff
0.320**
0.024

Regu
−1.907***
Govexg × Regu
0.193**
Concor
Govexg × Concor
N
212
172
No. of group
20
20
AR(−2) test
−1.10
0.272
0.84
Sargan/Hansen test
16.38
0.229
17.03
Note: *,**,***Significant 10, 5 and 1 percent levels, respectively

(8)
p-value

Coef.

p-value

0.457

0.000
0.000
0.016
0.930
0.011
0.000
0.081
0.074

0.081
−0.693***
0.232***
0.350*
0.004
0.385*
0.520***
0.227
0.438***

0.298
0.001
0.000
0.097
0.994
0.078
0.000
0.688
0.007

−3.597**

0.528**
192
20
−0.70
14.49

0.032
0.011

0.001
0.015

0.399
0.198

0.483
0.340

growth rate with each institutional indicator have positive impacts on economic growth.
These results confirm our arguments that the better institutional framework helps boosting
the effect of fiscal policy. This fact suggests that the better institutional quality reduces the
crowding-out effects (reduces neo-classical effects) and promotes the crowding-in effects
(enhances the Keynesian effects) of fiscal policy in emerging market economies. This finding
has strong contributions to both literature of fiscal policy and practice in implementing
fiscal policy in the context of emerging market economies. The essential requirements for
the more effective fiscal policy are macro-measures to improve the institutional
environment. This result also recommends that the empirical study in the field of fiscal
policy should consider the institutional framework of countries that would be a potential
explanatory factor. We then incorporate the external debt into the economic growth model
to test the non-linear relationship. The results are provided in Table VI.

The significant positive coefficient of external debt level and significant negative coefficient
of square of external debt level suggest that the external debt and economic growth has a
non-linear relationship. This result is consistence with our discussion and theory, which
shows strong implications for the long-term fiscal policy consolidations. Whereas, the
government has to implement fiscal consolidation for the long-term sustainability of the
economy. The negative coefficient of square of external debt level means that the external
debt is in line with the higher economic growth when it is in low level; it is in line with lower
economic growth when it is in high one. This result also requires deeper investigation for the
mechanism of this non-linear relationship. The results in Tables VII and VIII provide us
some interesting explanations.
By dividing the sample into two sub-samples: the low indebted countries (group 1) and
high indebted countries (group 2) and regress the impacts of government expenditure and
institutions on economic growth. We find that the increasing in government expenditure
in group 1 has significant positive impact on economic growth, while it has insignificant
negative impact in the group 2. The results suggest that the fiscal policy is effectiveness in
stimulating the economic growth when countries have low debt burden, but it loses the


Model
Dep. var: GDP growth

(9)
Coef.

(10)
p-value

Gdpg(−1)
0.132**
0.037

Gdppc(−1)
−0.873***
0.000
Capg
0.248***
0.000
Popg
0.585***
0.000
Credit
0.050
0.897
Patent
0.630***
0.001
Fdi
0.407***
0.000
Trade
0.197
0.694
Govexg
0.092
0.336
Debt
0.031**
0.030
Debt^2
N
172

No. of group
20
AR(−2) test
0.44
0.661
Sargan/Hansen test
16.29
0.234
Note: *,**,***Significant 10, 5 and 1 percent levels, respectively

Coef.

p-value

0.164**
−0.922***
0.253***
0.630***
0.150
0.736***
0.437***
−0.590
0.113
0.116***
−0.001**
212
20
−1.05
15.79

0.028
0.000
0.000
0.000
0.692
0.000
0.000
0.215
0.107
0.002
0.039
0.293
0.260

The
effectiveness of
fiscal policy

61

Table VI.
External debt stock
and economic growth

Model
(11) 8 countries with average debt o40% (12) 12 countries with average debtW 40%
Dep. var: GDP growth
Coef.
p-value
Coef.

p-value
Gdpg(−1)
0.030
0.761
Gdppc(−1)
−1.018***
0.000
Capg
0.291***
0.000
Popg
−0.306
0.618
Credit
0.712*
0.063
Patent
0.386***
0.001
Fdi
0.104
0.663
Trade
1.205**
0.048
Govexg
0.122*
0.068
N
78

No. of group
8
AR(−2) test
−1.01
0.312
Sargan/Hansen test
24.48
0.140
Note: *,**,***Significant 10, 5 and 1 percent levels, respectively

0.173**
−0.407*
0.193***
0.807**
−1.512**
0.286
0.026
2.069**
−0.077
126
12
−0.31
25.81

0.044
0.059
0.000
0.015
0.049
0.180

0.864
0.015
0.299
0.759
0.172

effectiveness when countries face to high burdens of external debt. These findings are
consistence with literature and our arguments. This means that the high indebted
countries have less fiscal room and the unfavorable terms in accessing the international
financial markets, while the high level of external debt creates constraints for the private
sectors so that their fiscal policies present the crowding-out effects. We believe that the
findings have significant contributions for literature, especially for the practice of fiscal
policy. In addition, the results in Table VIII provide us additional interesting facts. While
the fiscal policy is more effectiveness in the low indebted countries, the institutions are
more effective in promoting economic growth in high indebted countries. This result
suggests a very useful measure for the high indebted countries that they should not
promoted to use the fiscal policy to stimulating economic growth, otherwise they must
improve the institutional framework. As stated in previous findings, the fiscal policy
presents crowding-out effects in the high indebted countries so that they face to the

Table VII.
Government
expenditure and
economic growth
under two debt
level regimes


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Table VIII.
Institutions,
government
expenditure and
economic growth
under two external
debt level regimes

Model
Dep. var: GDP growth
Gdpg(−1)
Gdppc(−1)
Capg
Popg
Credit
Patent
Fdi
Trade
Govexg
Goveff
Regu
Concor
N
No. of group
AR(−2) test ( p-value)
Sargan/Hansen test ( p-value)
Note: *,**,***Significant 10, 5

(13)

(14)

(15)

Group 1

Group 2

Group 1

Group 2

Group 1

Group 2

0.021
−0.987***
0.293***
−0.705
0.443
0.470***
0.133
1.325**
0.106
−1.081**

0.169**
−0.422*
0.192***
0.801**
−1.606*
0.310
0.028
2.142**
−0.076
0.072

0.013
−0.881***
0.290***
−0.713
0.370
0.413***
0.211
1.308**
0.082

0.161*
−0.557**
0.189***
0.906***
−1.925**
0.507
0.062
2.282***
−0.078

0.016
−0.894***
0.271***
−0.690
0.538
0.402***
0.254
1.061*
0.084

0.158*
−0.569**
0.189***
0.782**
−1.904**
0.536*
0.039
2.367***
−0.078

−1.074**

0.667

−1.331**
86
8
0.193
0.143

0.963
126
12
0.716
0.199

78
126
78
8
12
8
0.314
0.752
0.360
0.173
0.159
0.116
and 1 percent levels, respectively

126
12
0.723
0.171

dilemma if they want to use fiscal policy to promote economic growth: they want to use the
fiscal policy but they have less fiscal room, while they are under the burden of external
debts and it makes fiscal policy less effective. Therefore, the rightful choice in this
situation is institutional improvement and revolution.

5. Conclusion
This study collects the annual data from World Governance indicators and World
Development Indicators of Worldbank for 20 emerging markets in the period 2002-2014 to
examine the effectiveness of fiscal policy in the relationships with institutional framework
and external debt burden. Applying the endogenous growth model with the common
elements of economic growth including labor, capital, technology, credit, trade openness,
and capital flow, we then incorporate the government expenditure to investigate the
effective of fiscal policy. As our most notable contributions, we examine the impacts of
institutions on the effectiveness of fiscal policy through the interaction terms between
government expenditure and institutional indicators including government effectiveness,
regulatory quality, and control of corruption. In addition, we examine the non-linear
relationship between external debt and economic growth, where this relation is investigated
more detail for its mechanism through the fiscal policy. Through GMM estimators for panel
data, the study presents some meaningful findings.
First, the fiscal policy presents the crowding-in effects in emerging market
economies in the period of 2002-2014. This result confirms the important role of fiscal
policy in the case of emerging market economies, it is also consistence with our arguments
and theory of Keynesian views. In fact, the emerging market economies present with the
low level of capital accumulations, the low level of financial development so that the
interest rates may not be too sensitive with the fiscal policy, while the fiscal policy is
essential to build the basic infrastructure for the economic activities of private sectors.
Thus, the fiscal policy is effective in promoting economic growth. This result suggests
that Vietnam should consider the fiscal policy as an effective policy in tackling the
downturn of the economic growth. Second, even the fiscal policy has positive effects on
economic growth; the study finds interesting evidences that fiscal policy loses this effect
in the case of high indebted countries. The results have significant contributions to both


theories and practice. Whereas, the external debt creates constraints for the effectiveness
of fiscal policy, especially in the case of high indebted countries. This relationship may

explain the mechanism for the non-linear relationship between external debt and economic
growth. Third, we find evidences that the improvement in institutions boosts the
effectiveness of fiscal policy. This notable finding has very useful contributions to
literature and implications for the practice in the case of emerging market economies.
In which, the institutions under aspects of government effectiveness, regulatory quality,
and control of corruption enhance the positive impacts of government expenditure on
economic growth. In addition, the empirical results also suggest us essential measures
for the government in dilemma of ineffective fiscal policy when they are in high indebted
level that they should focus on the institutional improvement, which enhances the
effectiveness of fiscal policy in one hand, it has positive impacts directly on economic
growth on the other hand.

Notes
1. See Hemming et al. (2002) for the more detail summary.
2. In total, 20 emerging markets are defined in introduction section and the number of emerging
market economies is due to the availability of data.

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Corresponding author
Nguyen Phuc Canh can be contacted at:

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